Choosing an insurance plan: 3 common mistakes

Behavioral finance — the study of why humans make irrational decisions about money — has made its mark on the world of investing in a big way. Look at the way many companies now both enroll employees into their 401(k) plans and ratchet up their deferrals. Both are now frequently done automatically; if you don’t want to participate or increase the amount you kick in, it’s up to you to opt out. Similarly, there are many plans where target-date retirement funds have replaced money market funds, as the investment default.

Although some believe this is too “Big Brother,” these tactics (the financial equivalent of hiding the broccoli in the mac and cheese) are a good thing. They point to success stats like the huge lift in participation rates when a plan automatically enrolls — and how that alone can help employees stash away more for retirement.

But what about in the world of insurance? A few weeks ago, I wrote about my trip to the Wisconsin Business School at the University of Wisconsin in Madison. While there, I spent time with Justin Sydnor, an assistant professor in the Department of Actuarial Science, Risk Management, and Insurance who conducts much of his research in the field of behavioral finance. We talked about the none-too-rational mistakes humans make when shopping in this confounding field — and how we can help ourselves through them.

Here are three biggies:

1. We focus on the wrong variables

Think about the last time you were asked to choose a health insurance plan. Whether you were shopping an exchange or your employer’s menu, chances are there were many features to consider: co-payments, doctor availability, and deductibles. “It’s very easy to focus on the features that turn out to not to be financially important while missing the ones that are,” Sydnor says. Specifically, we have a tendency to focus too much on deductibles because of the large numbers associated with them. That can be a mistake.

Try this instead: If the first filter you apply when you’re looking at policies is the deductible — and you go for a low one — you’ll end up looking at a bunch of high-priced policies and miss the lower-priced ones altogether. Instead, Sydnor suggest narrowing the universe by first looking at factors that don’t have a huge impact like the coinsurance rate and the health care providers you really want. By leaving the deductible comparison to the end, you’ll get a policy that’s better suited to your needs (and your wallet).

2. We don’t do the math

Premiums, whether you’re talking about auto insurance or health insurance, are typically not presented as a yearly number — but as a quarterly or monthly number. Deductibles, on the other hand, are presented as an annual number. And as Sydnor’s research has shown, many people are so laser tuned to that factor they end up paying more in overall premiums than they save on deductibles. “If you pay $450 more in annual premiums and that gets you a $500 lower deductible, it’s a $50 difference — and you’ve paid the $450 up front,” he explains. That’s not a smart move. Even less smart: “We’ve seen cases where people will pay a $600 difference for a $500 lower deductible.”

Try this instead. Look at the yearly premiums. If they’re quoted in monthly increments multiply by 12. If they’re quoted quarterly, multiply by four. (I know it sounds ridiculously easy, but far too many people don’t go the extra step.) Then look at the spread between the difference in premiums and the deductible. “If the two numbers are close buy the high deductible policy,” Sydnor says. “Otherwise, you’re essentially paying up front for a reduction in deductible later.”

3. We insure the wrong things

Have you ever bought insurance on your cell phone? Or taken out an extended warranty on a new electronic? Or opted for a low deductible on your car insurance because, you thought: “If I have a fender bender, I don’t want to have to come up with $1,400 to fix my car.” We do these things all the time — Sydnor explains — essentially spending money to protect ourselves against relatively small losses. At the same time we’re ignoring much bigger financial risks. “We’re not buying disability policies. Some homeowners aren’t buying excess liability,” he says. “If we took all the money we paid to cover ourselves for small risks and devoted it to unlikely but big ones, that would be a much better way to manage the risk in our overall lives.”

Try this instead: If you can’t afford to replace it, insure it. If you can afford to replace it, don’t. “My general principal is that unless you have a really good reason to believe you are highly special and are, for example, going to destroy five iPhones, you’re better off avoiding most coverage under $1,000 and focusing on the bigger risks,” Sydnor says.

“Insure the things you can’t replace by yourself like your house or your income and don’t pay for extra insurance on the small things. That’s what your emergency cushion is for.”